Economic Models: from theory to application n.2
Diminishing marginal returns is a concept of paramount importance in economics. Defined as an increasing disinterest in anything, diminishing marginal returns are found in most economic fields, representing the mere nature of human beings when it comes to making a choice.
For many years, the welfare state has been the main selling point of the Left. Defending a redistribution of income through taxation and financial aid in order to make society safer and better, the welfare state is criticised by some economic schools as being an intrusive intervention of the state into the private matters of economic agents.
Support for or against political parties defending the welfare state might appear to depend upon which economic school one believes in, or upon one’s ethics and moral beliefs. Perhaps, however, the interest in defending the worse-off members of our society is also prone to diminishing returns.
Europe saw welfare states flourish in the 20th century, with many European countries putting social security programmes in place. The European Union itself promotes many financial aids and other safety nets to ensure the protection and well-being of its citizens, but this interest has diminished over time. Is this the result of diminishing marginal returns?
What are diminishing marginal returns?
“Diminishing marginal returns” are three words which read like they shouldn’t be together. One could define diminishing marginal returns in a technical manner, explaining concavity of weird economic functions and employing many obscure terms; but instead, let’s spare ourselves from a collective headache and leave this mathematical nonsense on the side to focus on the intuition behind this concept.
Imagine you are given a blank sheet of paper, and nothing else, and you are asked to draw a house. You are quite unhappy, as without a pen, you cannot draw anything. You are unable to respond to this request.
Suppose now that you are given a black pen, or any coloured pen. Now you can draw the house. Your satisfaction increases drastically, as you went from being unable to do anything to being able to do almost everything with this pen and paper. You can draw, you can write. This step between no pen and a black pen was a jump towards your freedom and enabled your ability.
Now, you are given another pen – a red pen. You can now add colours to your drawing, maybe express shadows or differentiate the roof from the walls in this drawing of your house. Your satisfaction increases – but it increases by less than when you were given the first pen, because while this red pen lets you explore wider areas of your creativity, the very first pen you were given allowed you to go from nothing to almost everything. Hence your satisfaction increases, but by less than previously, that is in a diminishing way.
You are given many more coloured pens, until a point is reached at which you have all the colours that you could imagine; you are then given this beige-with-a-dash-of-ochre-coloured pen that you did not have previously. Your satisfaction increases, but by less than before; sure it is useful to have this pen, if you need this exact colour one day, but you might never need it, and it does not unlock that much of your potential. Hence, your satisfaction increases again, but by way less than previously.
This is the idea behind diminishing marginal returns. When you start with nothing and are given something, the returns increase – that is your satisfaction increase in this case – will be greater than any subsequent incremental increase. In economic terms, the marginal returns are decreasing; the return of one extra unit increases your satisfaction, but by less than when you received the previous additional unit.
Wow! Diminishing marginal returns are so great – but what’s the point?
Diminishing marginal returns are great because they are a pattern that we find in many aspects of social science – and maybe of life more generally speaking. They are crucial as they allow economists to capture economic agents’ behaviour. Often linked to means of production or to the utility – an economic measure of agents’ wellbeing – diminishing marginal returns might be found in broader areas of economics, and more generally in broader areas covering agents’ behaviour.
In particular, Inglehart and Flanagan (Inglehart & Flanagan, 1987) argue that this phenomenon of decreasing increases can be found in politics, and in particular in the support of redistributive policies. Upon studying several European countries, Inglehart found a weakening positive relationship between support for the welfare state and income equality, leading them to conclude that redistributive policies are accompanied by diminishing marginal returns.
Their idea is the following: when a society is greatly unequal and when income inequality is high, redistributive policies benefit a large share of the population. Indeed, where income inequality prevails, the richest citizens’ share of total income is substantially higher than their share of the population; for instance, the richest 10% of citizens may own 50%, 60% or even 70% of the total income, leaving less than half of the country’s income resources to the 90% remaining population. While perfect equality is unattainable, a great level of inequality as described in the example above can lead to discontent in the poorest parts of the population, who will demand redistributive policies to palliate for this inequality. When this poorest part composes the largest share of the population, support for a larger welfare state might win elections.
Yet, as a welfare state is implemented and equality improves, fewer people benefit from redistributive policies. The share of the population that truly benefits from it, and hence that supports it, becomes a minority that is insufficient to lead to the victory of parties fighting for more redistribution. That is, as the welfare state becomes more generous, support for more of these policies decreases. If the returns of expanding the welfare state are greater income equality, marginal returns of the support for the welfare state decrease as the welfare state expands; support for more welfare does increase with income, and yet the rate of increase decreases, until it reaches a stagnant – or even decreasing – point. Hence, support for the welfare state is a victim of diminishing returns.
… so what’s going on in Europe?
When comparing it to its counterparts, Europe is often seen as a model of the welfare state; European countries, and Nordic countries in particular, are often praised for their reduction of inequality and their well-functioning welfare states. Arguably this achievement is nothing but the result of redistributive policies implemented by left-wing parties during the 20th century.
Data source: World Inequality database
Yet while one might expect that such a wave would have turned Europe into a left-wing continent, many countries, including the most equal ones, are turning their backs on left wing parties. Struggling to get any support, social democratic parties are facing turmoil and struggle to attain power, sometimes leading to the decay of the party.
Are we observing Inglehart’s idea of “diminishing utility of economic determinism”? Recent work from Loxbo et al. (Loxbo et al., 2019) seems to suggest that such a diminishing increase relationship is indeed observed in European countries. Pulling data from 16 western European countries between 1975 and 2014, they find a concave relationship between welfare state generosity and support for social democratic parties, confirming the existence of diminishing marginal returns for welfare support. While European levels of inequality are among the lowest in the world, European support for social democracy might also decrease, endangering left-wing parties’ survival.
So what’s next?
Here’s what Loxbo et al. did not explore and that Inglehart suggested: decrease in the support for left-wing parties might not be due only to the decrease in support for welfare state, but more generally because of realignment among their partisans.
Inglehart draws a distinction between two types of voters; the materialistic and the post-materialistic. Materialistic voters are the ones at the bottom of the income ladder; the ones that did not benefit enough – or at all – from the welfare state to take them out of their shabby situation. Post-materialistic voters on the contrary benefited from the welfare state, and now may let themselves focus on issues diverging from income and thus materialistic matters, such as migration issues and LGBT+ rights.
As this chasm within left-wing parties’ compositions widens, social democratic leaders have to make a choice regarding their political strategy; should they keep on advocating for more redistribution, at the risk of losing the post-materialistic voters who would not benefit from it, or should they align with the new vision of post-materialistic partisans? An emphasis on income matters might drive post-materialistic voters towards new generation parties embodying their ideals, such as environmental causes, while a focus on social justice might ward off materialistic voters who are more likely to be conservative in their views as their financial needs have not yet been met. In all, left-wing parties have to make a choice that will cost them support.
Is this what we see in Europe? It might just be. With the 2019 European elections, we see that the traditional left-wing S&D party has been losing seats since 2004, while the Green party has been growing since then. Such a shift of parts of the voters might as well be due to the inability of the left to come up with a programme that responds to the social justice needs and concerns of many young voters, and perhaps that its weak attempt is driving the few remaining conservatives away.
© European Union,  – Source: European Parliament
And yet, this is not to say that these post-materialistic parties could become a majority either. Maybe as Inglehart and Flanagan suggest, voters can only enlarge their scope of advocacy once their own needs are met. If that is the case, these parties’ progressive attitudes might drive away the support of those who feel left out as they believe that their needs have not been met. Why would they support immigration policies when they barely get what they need from their own country? Why would they support such policies when some politicians are telling them migration is the cause of their misery? While such reasoning is arguably flawed, it might teach us a valuable lesson on dynamics between conservatives, progressives and populists. In advocating in favour of more social equality, one should not forget that we have not reached perfect income equality yet; and that as long as few will feel that there is unfairness, there will be room for a party to sweep in and harvest this anger.